Why Do Multinationals Have Lower Effective Tax Rates?

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J. Harold McClure

Thu, 2013-09-19 23:47

Subsidiaries of multinational corporations pay lower effective tax rates than their domestic competitors, possibly because affiliates are “hard to tax, ” and the benefits from integration tend to accrue to low-tax affiliates.

There’s been a lot of talk about multinationals paying lower tax rates than businesses based in a single country – with a lot of assumptions of foul play. This post takes a look, from an economist’s perspective, on how this could happen even when a company is playing by all the rules.

Recent economic research demonstrates that subsidiaries of multinational corporations (MNCs) pay lower effective tax rates than their domestic competitors. Dominika Langenmayr of the University of Munich recently posted two alternative possible explanations:

• affiliates are “hard to tax, ” and

• the benefits from integration tend to accrue to MNC’s low-tax affiliates.

The “hard to tax” explanation has been emphasized in the OECD’s Action Plan to limit base erosion and profit shifting, which is essentially a claim by various national tax authorities that MNCs are engaged in aggressive transfer pricing manipulation. The research Langenmayr notes, however, suggests that MNCs that play by the rules and engage in intercompany pricing consistent with the arm’s-length standard would tend to also face lower effective tax rates. She references two recent articles in the Journal of International Economics.

One paper examined the taxes paid by 33,577 European manufacturing entities and found that “on average, foreign owners pay 594 Euros per employee or about 56% less than domestic owners of similar subsidiaries.”

In the other paper, Langenmayr and co-author Christian Bauer explored why foreign-owned affiliates would be expected to pay lower taxes. In their explanation, the firms that are the most efficient are engaged in “foreign direct investment,” that is, sourcing production through foreign affiliates. As such, these companies tend to have lower production costs than their domestic counterparts. In such situations, traditional transfer pricing methodologies may give mixed results as to what should be interpreted as the arm’s length standard.

Bauer and Langenmayr coin the term “gorilla’s arm’s length,” which apparently refers to a standard where the intercompany price should reflect the market price of goods, which essentially is the Comparable Uncontrolled Price (CUP). An alternative approach would be to estimate the arm’s length price by examining the economic cost of production, which reflects labor costs, materials, and a reasonable return on the capital utilized by the production affiliate. This latter approach is often referred to as the Comparable Profits Method (CPM). Bauer and Langenmayr note that the market price may exceed the economic cost of production for integrated firms.

CUP and CPM often deliver different results for various reasons including the benefits from integration and location savings. In these situations, differences of opinion may arise as to how to interpret the arm’s length standard. The tax authorities in the manufacturing affiliate’s locale would likely prefer the results of the CUP approach so as to be able to tax the profits from the benefits of integration and location savings. The tax authorities of the parent corporation, however, would likely prefer the CPM approach hoping to tax these same profits.

While the OECD rightfully argues that there should be no double taxation, their Action Plan to limit base erosion and profit shifting may encourage disagreements between these tax authorities as to who gets to tax the benefits from integration.

As we already knew, the effective tax rate of a MNC is a complicated figure, especially when compared to a business operating within a single tax jurisdiction. While the politics of the situation are arguable, it’s clear, based on Langenmayr’s explanations, that this discrepancy is far from simple, and could have nothing to do with bending the rules.